Financial Reporting and Credit Ratings
CARE ConferenceNAPA, CAApril 20, 2007
Greg JonasManaging Director
Greg JonasManaging Director
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Agenda
Background about credit ratings
Calculation, process, role of financial reporting
Accounting issues and credit ratings
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Background on Ratings
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Background on Moody’s ratings
Ratings on $35 trillion of debt outstanding
170,000 corporate, government and structured finance securities
10,000 corporate relationships
100 sovereign nations
Most ratings are freely available
Proprietary research – 2,600 subscriber institutions, 400,000 users
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Corporate
– Financial institutions
– Corporate investment grade
– Corporate high-yield
Municipal
Sovereign
Structured finance
Scope of today’s discussion…
We are Here
We are Here
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Uses of credit ratings
CreditRatings
BuildingPortfolios Pricing
Contracts
RegulatoryRequirements
Trading
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Benefits of ratings for companies
Market access (gate keeping)
Expands breadth of market
Widens distribution
Improves liquidity
Improves pricing
Helps management with independent, outside perspective on company
Helps management monitor counterparty risk
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Due diligence efficiency
Multiple independent perspectives
Facilitates comparisons
Tool in portfolio management
Enhances secondary market liquidity
Relatively stable over time
Basis for performance benchmarks
Benefits of ratings for investors
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What does a credit rating mean?
Opinion on expected loss
Expected loss = (Probability of Default) x (Severity of Loss)
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Rating scale
Aaa
Aa(1-3)
A(1–3)
Baa(1-3)
Ba(1-3)
B(1-3)
Caa(1-3)
Ca
C
Minimal credit risk
In default,little prospect of recovery
InvestmentGrade
HighYield
Watch list =under review
Outlook =likely direction
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Historical Rating Distribution
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
1919
1924
1929
1934
1939
1944
1949
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
Aaa
Aa
A
Baa
Ba
B
Caa-C
US Non-Financial Corporates
By Issuer Count
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Average Loss and Default Rates
AaaAaABaaBaBCaaCaC
SeniorUnsecured
RatingDefault
Probability1
ExpectedLossRate1
0.002%0.052%0.380%1.32%7.48%19.94%48.27%100%100%
0.001%0.026%0.190%0.66%3.74%9.97%24.13%50%80%
1 4 year time horizon
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Average Cumulative Expected Loss:Senior Unsecured Debt
1 4 7 10 13 16 19
AaaAaABaaBaB0%
10%
20%
30%
Years OutRating
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Assume Moody’s rates a company’s senior unsecured debt “A2, on review for possible downgrade” - What does this mean?
The company’s debt is investment grade
Based on historical averages, investors can expect to lose 0.19% from a portfolio of all debt obligations at this rating over a 4-year period
Based on an average loss in default of 50%, the probability of the debt defaulting is 0.38%
Because debt is on review, it will probably trade as a Baa1 rated debt (2 notch discount)
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Relationship between long-term and CP ratings
Aaa
Aa1Aa2Aa3
A1A2A3
Baa1Baa2Baa3
High Yield
Prime-1
Prime-2
Prime-3
Not prime
Long-Term CP
InvestmentGrade
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Types of high-yield ratings
Company Instruments
Corporate Family Rating
(CFR)Risk of Loss
Speculative Grade Liquidity
(SGL)
Loss Given Default
(LGD)
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Corporate Family Rating
Expected loss = (Probability of Default) x (Severity of Loss)
Assumes = Corporate family is a single entity with one class of debt
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Types of high-yield ratings
Company Instruments
Corporate Family Rating
(CFR)Risk of Loss
Speculative Grade Liquidity
(SGL)
Loss Given Default
(LGD)
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Instrument ratings
B1
Senior Secured
Subordinated
CorporateFamily Rating Debt Classes
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0
10
20
30
40
50
6070
80
Bank Loans SeniorSecured
SeniorUnsecured
Subordinated PreferredStock
Defaulted Debt Recovery Rates
%
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Instrument ratings
B1
Senior Secured
Subordinated
CorporateFamily Rating Debt Classes
InstrumentRating
Ba2
B2
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Loss Given Default Rating
LGD Assessment Loss Range
LGD1 0% - 10%
LGD2 10% - 30%
LGD3 30% - 50%
LGD4 50% - 70%
LGD5 70% - 90%
LGD6 90% - 100%
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Instrument ratings
B1
Senior Secured
Subordinated
CorporateFamily Rating Debt Classes
InstrumentRating
Ba2
LGD3
B2
LGD4
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Assume Senior Secured Debt is Rated Ba2, LGD3 (40%) - What does this mean?
The debt is speculative grade
Based on historical averages, investors can expect to lose 3.7 percent from a portfolio of these debt securities over a 4-year period
If the security defaults, investors can expect to lose about 40% of the principle and accrued interest
The probably that the company will default on this security is about 10%
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Types of high-yield ratings
Company Instruments
Corporate Family Rating
(CFR)Risk of Loss
Speculative Grade Liquidity
(SGL)
Loss Given Default
(LGD)
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SGL
SGL 1 SGL 2 SGL 3 SGL 4
Operating cash flow + cash on hand
SufficientSufficient except for extra capex
Breakeven and limited cash
Insufficient
Committed facility
UndrawnNeeded only for extra capex
Reliant and used, but not fully
Needs external sources
CovenantsCompliant with headroom
Compliant Barely compliant
Likely violation
Back door Present Present but impairment Unlikely Little
Assets Unsecured Mostlyunsecured
Mostly secured
Few alternatives
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Rating qualityWhat investors want from ratings
Accurate (relative ranking of credit risk)
Low ratings in advance of default
Stable (few rating reversals)
Don’t incorporate market price information (self-fulfilling, pro-cyclical)
Independent, stabilizing force
Separate point of view from each agency
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Rating qualityKey performance measures
Investment grade defaults
Accuracy measure (90% = average defaulter rating lower than 90% of all issuers)
Stability measure
– # of issuers with rating changes divided by total number of rated issuers
– # of issuers with 3+notch changes divided by total number of rated issuers
Rating reversals
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Ways to assess credit risk
Fundamental approach (e.g. Moody’s credit ratings)
Market implied ratings (e.g. bond or CDS prices)
Mathematical models
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Fundamental ratingsNot quite as accurate but more stable…
Moody’sBond-
ImpliedMDP
1-year accuracy 79 87 76
5-year accuracy 63 66 55
Average rating B2/B3 B3/Caa1 B2
Rating action rate 25 98 76
Large action rate 5 26 32
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Calculation, Process, Role of Financial
Reporting
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Fundamental Analysis: Areas of Analysis
Issue Structure
Company Structure
Operating / Financial Position
Management Quality
Industry / Regulatory Trends
Sovereign / Macro Economic
Fin
an
cial
Rep
ort
ing
Pro
bab
ilityo
f Defa
ult
Severity
of L
oss
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Rating data flow…
DATABASE
Rating Methodologies Adjustment Worksheets
Company Reports
XYZ Company
Adjusted Financial Statement Data
Adjusted Financial Statement Data
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Reasons to adjust reported amounts
Apply accounting principles that we believe more faithfully capture underlying economics
Identify and segregate effects of unusual or non-recurring items
Improve comparability by aligning accounting principles
Reflect estimate or assumptions that we believe are more prudent
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Moody’s Standard Adjustments
IFRS Only
Capitalized development costs
Income statement presentation of interest cost related to certain discounted liabilities
U.S. GAAP Only
LIFO Inventories
All Accounting RegimesDefined benefit pension plans
Operating leases
Employee stock compensation
Hybrid securities
Securitizations
Unusual / non-recurring items
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Purpose of U.S. GAAP adjustments
Adjustment Purpose
Pensions Eliminate smoothing
Leases Capitalize operating leases
Capitalized interest Expense capitalized interest
Stock compensation Expense and flag on CFS
Hybrid securities Apply Moody’s framework
Securitizations Treat as securitized borrowings
LIFO Adjust balance sheet to FIFO
Unusual items Highlight core earnings
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Typical timeframe for data
Historical Projected
5 years 3 years
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…more rating data flow
Industry / Macro Economic Data
Industry / Macro Economic Data
Adjusted Financial Statement Data
Adjusted Financial Statement Data
Other Company Specific Data
Other Company Specific Data
AnalysisAnalysis
Rating Committee Package and
Recommendation
Rating Committee Package and
Recommendation
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Industry methodologies…
Key metrics
Benchmark and rate
Weigh
Indicative Rating
Other qualitative factors
Final rating
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Size, Scale and DiversificationTotal Revenues (20%)Segment Diversification (7.27%)Concentration of customers (7.27%)
Product and Portfolio ProfitabilityR&D as a % of Sales (7.27%)EBIT Margin (7.27%)ROA (7.27%)
Financial PoliciesReliance on acquisitions, share buy-backs and dividends (7.27%)Debt / Book Capitalization (7.27%)Debt / EBITDA (7.27%)
Key metrics – Global Medical Devices Industry
Financial StrengthCFO / Debt (7.27%)Free Cash Flow / Debt (7.27%)EBIT / Interest Expense (7.27%)
Note− Factor weight in parenthesis− Financial metrics in Italics
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Key metrics – Most Commonly Used Moody’s Industry Rating Methodologies *
Metric Category Metric
% of Methodologies
Including Metric
Size Revenue 58%
Profitability EBIT (or EBITA) Margin 38%
Return EBIT (or EBITA) / Avg. Assets 30%
Free Cash Flow / Debt 55%
Retained Cash Flow / Debt 30%
Retained Cash Flow / Net Debt 28%
Coverage EBIT / Interest Expense 45%
Debt / EBITDA 50%
Debt / Capital 40%Leverage
Cash Flow
* To date Moody’s has published 40 industry rating methodologies.
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Key metrics – Global Medical Devices Industry
An example “Rating Grid”…
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Industry methodologies…
Key metrics
Benchmark and rate
Weigh
Indicative Rating
Final rating
Industry structure
Financial policy
Management quality
Contingent liabilities
Aggressive accounting
Weak accounting control
Governance risk
Event risk
Other qualitative factors
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An Example Rating: Stryker Corporation
Industry / Macro Economic Data
Industry / Macro Economic Data
Adjusted Financial Statement Data
Adjusted Financial Statement Data
Other Company Specific Data
Other Company Specific Data
AnalysisAnalysis
Rating Committee Package and
Recommendation
Rating Committee Package and
Recommendation
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An Example Rating: Stryker CorporationAdjusted Financial Statement Data Industry Model Rating Grid
Other Company Specific DataFinancial projections
Strategic plans
Details of significant transactions
Access to management / directors
Industry / Macro Economic Data
Other Qualitative ConsiderationsRelatively high degree of exposure to the orthopedics market
Potential litigation stemming from DOJ investigation
Potential for acquisitions in consolidating market place
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An Example Rating: Stryker Corporation
Rating Committee Package and
Recommendation
Rating Committee Package and
Recommendation
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Accounting Issues and Credit
Ratings
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Moody’s Specialist Groups
Group Focus
AccountingCredit-relevant issues related to
financial reporting
GovernanceImpact of governance issues on
credit risk
OBS/StructuredCredit impact of off-balance sheet
structures
Risk ManagementImpact of complex financial
instruments on credit risk
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What do accounting specialists do?
Area of Responsibility
Time Allocation
Help get ratings right 40%
Publish on companies and topics 30%
Train Moody’s analysts 15%
Communicate with outsiders 15%
Are analytical adjustments useful?
Evidence of aggressive accounting?
Evidence of weak reporting control?
Impact of financial reporting meltdown?
The Big Questions
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Getting ratings right –Evidence of aggressive accounting
MisleadingAccounting
AnalystConcern
GovernanceConcern
Red Flag Metrics
Comment Letters
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=
Category “B1”
weakness
General uncertainty about
company’s reporting2
Rating that does not yet reflect
uncertainty+
Negative rating action
+
2Examples:Delinquent filingsContinuing restatementsAggressive accountingInvestigationsWeak remediation
Getting ratings right –Evidence of weak reporting control
1Pervasive weakness, e.g.:Not enough folksInsufficient skills
Evaluating the impact control weakness on ratings…
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404 problem #1: reports lag reporting problems
Restatements 38%
None 5%
Both 15%
Adjustments and Other 42%
Types of Financial Reporting Errors Preceding Material Weakness Disclosures
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404 problem #2: No one is talking about fraud
5%
95%
Fraud-Control Disclosures
No Fraud-Control Disclosures
Percentage of Companies with Material Weaknesses Citing Fraud Controls
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Getting ratings right -Impact of a meltdown…
Company Rating Before Problem Rating After Problem
Adelphia High Speculative Grade Low Speculative Grade - Rating WithdrawnAIG Highest Investment Grade High Investment GradeCendant High Investment Grade High Speculative GradeComputer Associates Low Investment Grade Speculaltive GradeDelphi High Speculative Grade Low Speculative Grade - Rating WithdrawnDollar General Low Investment Grade High Speculative GradeDuke Energy High Investment Grade Speculaltive GradeDynegy Low Investment Grade Low Speculative GradeEnron High Speculative Grade Low Speculative Grade - Rating WithdrawnGlobal Crossing Speculative Grade Low Speculative Grade - Rating WithdrawnHealthSouth Low Investment Grade Low Speculative Grade - Rating WithdrawnLucent High Investment Grade Low Speculative GradeQwest Low Investment Grade Low Speculative Grade - Rating WithdrawnRiteAid High Speculative Grade Low Speculative GradeSunbeam Speculative Grade Low Speculative Grade - Rating WithdrawnTyco High Investment Grade Speculaltive GradeUnited Rentals High Speculative Grade Speculaltive GradeWaste Management Low Investment Grade High Speculative GradeWorldCom Low Investment Grade Low Speculative Grade - Rating Withdrawn
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Reporting meltdown… factors to consider
Covenant violations?
Will bond holders accelerate?
Is backup liquidity ready and bulletproof?
What will banks do?
Crisis of confidence with customers and vendors?
Management distraction?
Management’s plan to mitigate damage?
Rating impact when we don’t have #’s - basis to continue ratings?
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Published materials – 2006 examples
Fair Value Option Leveraged leases
Standardadjustments
Volumetric production payments
Short-cutmethod
Pooling adjustmentsat oil and gas companies
Internally funded pension plans
Fair value for servicing assets
Pensions -Phase 1
Expensingstock comp.
404 reporting -Year 2
Backdating
Uncertain taxpositions
Multi-employer pensions
Pension reform
SAB 108
Internalaudit
Events
New Rules
Adjustments
Accounting? Credit Impact? Data?Content
Financial Reporting and Credit Ratings
CARE ConferenceNAPA, CAApril 20, 2007
Greg JonasManaging Director
Greg JonasManaging Director